“Loan to Own” Debtor: Public Interest Overrides Bad Faith Filing

In re 1701 Commerce, LLC, 477 B.R. 652 (Bankr. N.D. Tex. 2012)

The capital stack for Presidio Hotel Fort Worth, L.P. consisted of (1) a senior loan of $39.6 million from Dougherty Funding, LLC, (2) a junior loan from Vestin Originations, Inc. and (3) a 20‑year tax agreement with the City of Fort Worth pursuant to which the City made annual grant payments.

The debtor (1701 Commerce, LLC) was a wholly owned subsidiary of Vestin that was created shortly after the borrower (Presidio) indicated that it was likely to default on both the senior and junior loans.  It was a special purpose entity formed to take an assignment of the junior loan and then to own the property in order to limit the potential exposure of the Vestin affiliates holding the loan prior to the transfer.  By the time this bankruptcy was filed, the borrower had transferred the hotel project to the debtor by deed-in-lieu of foreclosure.

As background, both the senior lender and the newly formed 1701 Commerce as junior lender sent notices of default after the borrower defaulted in December 2011.  On January 17, 2012, 1701 Commerce posted the property for foreclosure as the junior lender.  The senior lender and borrower unsuccessfully sought to prevent the foreclosure.  Just before the scheduled foreclosure, the borrower transferred title to the property to 1701 Commerce by a deed in lieu of foreclosure.  The senior lender then posted the property for a March foreclosure.  1701 Commerce obtained a TRO based on a dispute about the terms of the Intercreditor Agreement between Dougherty and Vestin.

On March 26, 2012, the evening before an evidentiary hearing on whether the TRO should be lifted or continued, 1701 Commerce filed for relief under Chapter 11 of the Bankruptcy Code.  The senior lender argued that the debtor filed its case in bad faith and thus it should be granted relief from the automatic stay or the case should be dismissed.

One basis for granting relief from the stay is that the debtor has no equity in the property and it is not necessary for an effective reorganization, as set forth in Section 362(d)(2) of the Bankruptcy Code.  In this case it was clear that the current value of the property exceeded the senior lender’s claims (which had grown to approximately $44.5 million), but it was debatable whether the value was greater than the sum of the senior and junior loans.  However, the court found that the junior loan was extinguished through merger in connection with the deed in lieu.  Consequently the debtor had equity and the property was clearly necessary for the reorganization, and accordingly Section 362(d)(2) did not provide a basis for relief from the stay.

Alternatively, the senior lender argued that the case was filed in bad faith, and therefore “cause” existed for relief from the stay or dismissal of the case.  Factors the courts have found indicative of a bad faith filing include:  (1) the debtor has a single asset encumbered by secured liens; (2) the debtor engaged in improper prepetition conduct; (3) the debtor’s property was posted for foreclosure, and the debtor unsuccessfully tried to prevent it in state court; (4) the bankruptcy filing enabled the debtor to evade court orders; (5) the debtor employs few or no employees other than its principals; (6) there is little or no cash flow or source of income to sustain reorganization; and (7) there are few if any unsecured creditors and their claims are relatively small.

The court found that a number of these factors were present in this case – including single asset, no employees (since the individuals working at the property were employed by the management company), improper prepetition conduct (relating to the Intercreditor Agreement), filing to avoid a court order lifting the TRO, and the bulk of the unsecured claims scheduled by the debtor were in fact debts owed by the management company.

The court concluded by noting that where “’a one‑asset entity has been created or revitalized on the eve of foreclosure to isolate the insolvent property and its creditors,’ the inference of bad faith is particularly strong.”  Consequently, the court found that the bankruptcy was filed in bad faith, which typically would constitute cause warranting relief from the stay or dismissal.

However, the court went on to assert that it must consider the legitimate interests of others in deciding whether to grant either of the motions.  It considered the public interest served by preserving value and jobs where possible, and noted that the city tax agreement reflected the importance of the property, with the public having a significant interest.  The court concluded that the result of granting relief from the stay or dismissing the case would be a return to state court with the result that the property would “serve as a fraying rope in a continuing tug of war between Dougherty and Vestin,” while leaving the hotel in bankruptcy would allow the court to monitor and oversee operations, protect the hotel project from lawsuits through the automatic stay, and appoint a neutral trustee if necessary to manage the property.

On the other hand, the court recognized that the value of the senior lender’s collateral could decline.  Although the senior lender had a substantial equity cushion, the fact that the appraised value in September was $65.6 million and $55 million the following March indicated that the value had already gone down significantly over the course of six months.

So the court required that the debtor deposit $1 million as further security for the senior lender as a condition for continuing the automatic stay.  If the debtor did not obtain confirmation of a plan of reorganization by a specified deadline, the cash would be used first to pay the senior lender for any deficiency in its collateral, next to pay administrative expenses, and third to Vestin.

Not all courts would find that these facts support a finding of bad faith, although the presence of the “new debtor syndrome” (a newly created debtor formed for the purposes of filing bankruptcy) would cause many to come out on the side of bad faith.  However, once a court has found bad faith, it would be very unusual to decide that the public interest overrides granting relief from the stay or dismissal based on that finding.

Perhaps the lesson to be learned from this case is that none of the parties can predict what will happen in a bankruptcy under these circumstance with any degree of certainty.

Vicki R. Harding, Esq.

About BankruptcyRealEstateInsights

Vicki R. Harding was a partner in the Detroit office of Pepper Hamilton LLP who moved to Arizona seeking warmer weather. Ms. Harding continues to handle commercial transactions with an emphasis on real estate and bankruptcy issues (but no longer owns a snow shovel).
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2 Responses to “Loan to Own” Debtor: Public Interest Overrides Bad Faith Filing

  1. tina brown says:

    I am new to this arena, so I had to look up the term Bad Faith. For anyone that is interested, I found a good definition here https://realestatemetro.com/real-estate-terms/bad-faith

    • The court included a discussion of bad faith in this case as follows:

      “Courts have identified a number of factors indicative of a bad faith filing, including:

      (1) the debtor has one asset, such as either undeveloped or developed real property, encumbered by secured creditors’ liens,
      (2) debtor has engaged in improper pre-petition conduct,
      (3) the debtor’s property has been posted for foreclosure, and the debtor has tried unsuccessfully to prevent this foreclosure in state court,
      (4) the filing of bankruptcy enabled the debtor to evade court orders,
      (5) the debtor employs few or zero employees other than its principals,
      (6) there is little or no cash flow or source of income to sustain a reorganization, and
      (7) there are few if any unsecured creditors and their claims are relatively small.

      Little Creek, 779 F.2d at 1072-73; Trident, 52 F.3d at 131. [Footnote 18: Not all of these factors need to be present for bad faith to exist. …]

      Furthermore, where, as here, ‘a one-asset entity has been created or revitalized on the eve of foreclosure to isolate the insolvent property and its creditors,’ the inference of bad faith is particularly strong.”

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